New rules on defaults may bolster sec lending – report

The new rules in the US setting out how securities lending transactions will be dealt with in the event of a default of a major financial institution, notably a systemically important financial institution (SIFI), may provide some improvements but a number of uncertainties remain, according to a report by BNY Mellon and Finadium.

The new rules in the US setting out how
securities lending transactions will be dealt with in the event of a default of
a major financial institution, notably a systemically important financial
institution (SIFI), may provide some improvements but a number of uncertainties
remain, according to a report by BNY Mellon and Finadium.

The report notes the current efforts towards
creating more stable liquidation or resolution regimes are ongoing and
represent changes for the securities lending industry. “While much regulation
stills need to be written, the potential for improvement and increased clarity
has been highlighted by the ongoing administration of Lehman Brothers,” says
the report. “Recent settlements on securities lending transactions for Lehman
Brothers, four years after the firm’s failure, illustrate the potential benefits
of a well-defined resolution regime. For beneficial owners, new regulations
will serve to reduce fears of counterparty defaults arising from bankruptcy and
give more comfort to the overall stability of the financial system.”

The report notes how the Dodd-Frank Orderly
Liquidation Authority’s (OLA) rules will impact on securities lending:

- Federal Deposit Insurance Corporation’s (FDIC)
authority to take over banks will be expanded to include derivatives clearing
firms and central credit counterparties. Broker-dealer subsidiaries of banking
organisations may also be covered. However, for any broker-dealer that is a
member of the Securities Investor Protection Corporation (SIPC) and is
registered with the Securities and Exchange Commission, the FDIC must appoint
SIPC as trustee. That broker-dealer will be liquidated under the provisions of
the Securities Investor Protection Act (SIPA) with one important exception. All
qualified financial contracts to which the broker-dealer is a party are removed
from the SIPA proceeding and are dealt with by the FDIC under the provisions of
OLA. Securities lending and repurchase contracts along with most other
counterparty based instruments are considered qualified financial contracts and,
as a result, would be subject to the provisions of OLA.

- Given the FDIC’s mandate to
minimise taxpayer losses, whether a securities lending contract is transferred
to a bridge company could be in large part dependent on the level of
collateralisation. All qualified financial contracts for a single counterparty
will either be transferred to the bridge company or remain in the insolvent
entity. Overcollateralised securities loans would most likely be transferred to
the bridge entity unless the counterparty had certain other contracts that were
problematic. However, in the event that a counterparty’s loan transactions were
undercollateralised by an unknown but sufficient amount, this transaction could
cause the FDIC to decide not to transfer the qualified financial contracts for
that counterparty to the bridge entity. The industry continues to have
discussions with the FDIC in order to get more clarity around exactly how
decisions to transfer qualified financial contracts will be made. Although
there have historically been few losses in securities lending owing to
counterparty defaults, the potential to have some assurance that valid and
properly collateralised securities loans would be transferred to a bridge
company would lend stability to both the markets and lending operations.

- The new OLA stay marks a
change from how securities loans are dealt with in the bankruptcy of a
broker-dealer that is a member of SIPC. In a SIPA proceeding, loans
collateralised by cash are not subject to a stay. For loans collateralised by
securities collateral, the OLA stay is likely an improvement over SIPA rules
that could impose stays on terminations of five days or, in the case of Lehman
Brothers, significantly longer. At the same time, new questions are raised
whether all securities lending counterparties would be grouped by holding
company or whether each subsidiary would be considered a separate legal entity.
When evaluating solvent transactions on a counterparty basis, regulators may
assess securities loans by each underlying lender as opposed to the agent who
made the loan.

Compared to today’s bankruptcy rules, the report
says the new regulatory initiatives offer several direct benefits:

- An understanding that authorities have the
right to take over a failing institution before bankruptcy occurs, to separate
good assets from bad, and to manage those assets for the greatest benefit of
shareholders and creditors.

- A reasonable expectation that
fully collateralised securities loans would be transferred to the bridge
entity.

The report concludes that while difficult
situations may continue to arise, particularly for undercollateralised
securities loans that may prevent transfer to a bridge entity, the likelihood
is that crisis resolution regimes worldwide will benefit the securities lending
market. “Regulators are working to present transparent resolution processes for
failed institutions,” says the report. “The more that this can occur, the more
likely that market participants will extend credit to counterparties and
generate both market liquidity and returns.”